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Austerity Measures Strain the Portuguese Government

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Portugal entered a deep political crisis in the past two days, when the finance minister and the foreign affair minister resigned in the context of growing social unrest against austerity measures. These resignations jeopardize the government of Prime Minister Pedro Passos Coelho, who came to power only two years ago. While this situation will bring instability to financial markets, Portugal still has some breathing room before the crisis becomes dangerous for the rest of the eurozone.

Political instability in Portugal is the result of two factors: social unrest because of austerity measures applied by Lisbon and political infighting in the ruling coalition. Passos Coelho won the Portuguese general elections in June 2011, a month after Lisbon requested a bailout to the European Union and the International Monetary Fund. During his first year in government, the ruling coalition enjoyed a relatively smooth political situation. This allowed Lisbon's lenders to present Portugal as a successful bailout case, along with Ireland and unlike Greece.

But the Portuguese are becoming increasingly tired of the spending cuts and tax hikes applied by the government. Portugal is in recession, and its economy contracted 3.2 percent last year, its sharpest annual downturn in four decades. Unemployment was 17.6 percent in May, the third largest in the European Union after Spain and Greece. Portugal’s main unions held a general strike in late June, after hundreds of thousands of people protested austerity in March. This led to tensions within Portugal's ruling coalition, as the minority party in Coelho''bal Cavaco Silva is currently holding meetings with the country’s main political parties. Passos Coelho insisted that he will not resign, but early elections cannot be ruled out. If that happens, most of the mainstream parties in Portugal are pro-European and won't substantially change direction. A new government will probably request softer deficit targets to the European Union, something that is likely to be accepted by Brussels, as the EU Commission has recently relaxed its targets for several eurozone members including Portugal.

Additionally, the promise of intervention in debt markets made by the European Central Bank so far worked to keep bond yields relatively quiet. The worst-case scenario would be for the ECB to be forced to honor its promise and purchase Portuguese debt, or for the troika to concede Portugal a second bailout. But even that would only happen in late 2013 or early 2014. IMF and EU officials are expected to visit Lisbon later this month to negotiate the next tranche of the bailout. A fast agreement would give Portugal some fresh air for the rest of the quarter.

Political uncertainty is likely to remain high in Portugal during the second semester of the year. But with the Portuguese bailout only ending in mid-2014, Lisbon still has some time to try to calm markets and avoid a new bailout, before the crisis becomes dangerous for the rest of the eurozone.

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